Calculated Risk, one of my favorite finance and economics blogs, has a great article written by the late Tanta on The Psychology of Short Sales. The piece really hit home for me, because during my recent search for new quarters, I ended up drooling over a lot of short sale listings, only to be warned by my agent that they often take a very long time to execute and frequently fall through. I quickly cooled to the concept.

On paper, short sales are the ultimate win/win for an upside-down homeowner who wants to “walk away,” and a lender who wants to minimize their loss. It lets both parties avoid foreclosure, prevents a house from sitting empty and potentially becoming a target for vandalism, squatters, and generally a source of neighborhood blight, and lets the homeowner remain on the property and leave gracefully when it sells. Plus, potential buyers get a house that hasn’t been trashed by a bitter ex-owner, or had its pipes freeze and burst due to over-winter neglect. Triple win, right?

That’s on paper. In practice, things often don’t work out so well. Because of the way short sales work, there’s often a disconnect between what the various parties involved in the deal think the property is worth. If they can’t reconcile their views, there’s no sale and the property goes back on the market, and eventually to foreclosure.

The biggest difference between a short sale and a traditional bank-owned post-foreclosure property (a “REO”, or “real estate owned”) is that in the latter case, the bank has already taken possession of the property, probably had it assessed, and accepted that they’re going to take a non-negligible loss. It’s just a non-performing asset sitting on their books at this point, one that they’d presumably like to unload at the earliest possible opportunity at an acceptable price. Contrast this to a short sale: the bank has just learned that the current homeowner can’t make their payments and wants out, and has responded by telling them to get a listing agent and put it on the market. They haven’t really written anything down yet. The big loss is still to come.

To a buyer, a short sale property ought to be more attractive than a REO, because it hasn’t been sitting vacant or gotten trashed during a ugly eviction. However, buyers quickly learn to beware these six words in any listing: “offers subject to third-party approval.”

When a buyer makes an offer on a REO, the offer goes to the bank and they get a pretty straightforward thumbs-up or thumbs-down. Either the offer is acceptable and it sells, or it isn’t and the bank is content to let it stay on the market a bit longer. Since the bank already owns the house, they just want to get the most for it they can.

When an offer is made on a short-sale property, it gets forwarded by the listing agent to the bank, who has the choice of whether to accept it or not. If they accept it, they’re almost certainly taking a loss and accepting a writedown on the original mortgage. There is a big psychological difference between this and the REO case, it seems to me: in a REO situation, the bank is trying to recoup as much as it can of an already-realized loss; in a short-sale, the bank is actually taking the loss as part of accepting the offer.

This psychological difference seems to manifest itself in the relative speed with which banks process the two different types of offers. REO offers get decisions rendered quickly; short sale offers can take months to process, during which both the buyer and seller live in uncertainty. This uncertainty causes buyers to make fewer offers on short sales than on REOs, and to offer less for short sales than they might otherwise. In theory there’s no reason why short sales should sell for much below what a regular owner/buyer sale would, but in practice they go for something closer to REO prices. This difference is, to my eyes anyway, almost completely due to the perceived arduousness of the short sale process.

In addition, there’s often a failure on the part of buyers and lenders to understand how the short sale benefits the other party, and how this affects the price they’re willing to accept. This is what Tanta explores in the Calculated Risk article. Lenders are only interested in a short sale if it results in a price that’s significantly (more than 40%) greater than what the property would fetch as a REO, post-foreclosure. Buyers, on the other hand, often try to bid less than what the property would fetch as a REO, on the assumption that the lender ought to be willing to take a little less on a short sale than they would as a REO, since they’re avoiding going through foreclosure. Hence, no deal.

In order to make short sales a more viable option for distressed homeowners who find themselves upside-down on their mortgages and unable to pay for them (or who simply want out and can’t sell normally and cover the mortgage), I can think of several things that need to happen:

• Banks and other lenders need to assign more staff to “special assets” and other pre-foreclosure divisions, and realize that they can avoid needless trouble and expense by going the short-sale route versus foreclosure. They need to gear these divisions to providing fast up-or-down decisions on short sale offers, and empower employees to write down assets significantly (at least as much as the delta between the REO price and the loan face value) in order to make deals happen quickly.

• Prospective buyers need to be better-educated about how short sales work, not only from their own perspective, but also from the owner’s and lender’s. They need to understand why a lowball, sub-REO offer isn’t going to fly with the lender. For a short sale to work, three parties — the owner, the buyer, and the lender — need to feel like they’re making out better than they would have via foreclosure. Offering substantially less than a property would fetch as a REO doesn’t allow that to happen.

• Homeowners considering a short-sale, whether in financial distress or not, need to be better about selling their properties. They need to work hard to make it clear to buyers that they’re not selling a REO, and that the property is inhabited and well-maintained. If a house looks like a foreclosure property, it’s going to get offers that reflect that, and it will almost certainly end up as a foreclosure property eventually. I saw several short-sale properties during my recent search that were frankly worse than the average REO, and that just isn’t going to work.

As it turned out, I didn’t make any offers on the short sale properties that I looked at. Given the time available before I have to be out of my current rental, it just doesn’t make sense. And I definitely wasn’t alone: many short sale properties had been on the market for hundreds of days, while REOs are being snapped up almost daily by hungry buyers armed with low rate pre-approval letters.

Making the reality of short sales better match the concept would provide affordable homeownership to many buyers, a dignified ‘out’ for distressed owners, and smaller losses to lenders and their investors. But a lot has to happen before that will be the case.